Archive for March, 2017

Figuring out the actual values of business assets is a common task in business appraisals. Pick up the property records in a typical company, and you are looking at the book values. Sounds easy, right?

Welcome to the real world. The fact is that business assets can and do disappear, while being on the books. On the other hand, some valuable assets can be in use while not on the books at all.

Don’t expect that this difference comes out in the wash. Your accountant may want to offset such imbalances, but two wrongs don’t make it right. How do business assets wind up on the company’s books? Usually, your accountant keeps records of business assets using their original cost of purchase less depreciation.

What this book value does not represent is the true fair market value (FMV) of the asset. To make matters even more interesting, the fair market value can be estimated on the premise of the asset in use or in exchange. The first assumption is that the asset will continue being used in business operations. The second is that the asset will be offered for sale. The value may differ by quite a bit.

The key point is that the price you paid for a piece of equipment or software application years ago may bear no resemblance to what the asset is worth today. Technological obsolescence has really changed the game in asset valuation. Just because a custom software cost you, say, $100,000 in 2000 does not mean its value is anywhere near that today.

Purchase price allocation calls for business asset valuation

Even so, there are examples in business appraisals when current fair market values of some business assets are close to their book values. This is more likely to be the case if you are valuing the entire company and the assets are expected to be in use. If the business is offered for sale, purchase price allocation across the assets is one scenario when accurate asset valuation is needed.

Market value of business assets – another perspective

If the company plans to divest of some of its assets, you may find that the market place has a very different idea of what these assets are worth. This comes up when business assets are viewed as a collateral against a bank loan. Your lender is not interested in using the assets. Instead, the likely selling price in the event your company defaults is important.

Liquidation value – when assets are sold at an auction

The appraisers call this the liquidation value. It is established at an auction attended by the equipment brokers or other companies looking to get usable assets at a discount. You can bet on the selling prices being lower than the book value in these situations.

Does the value of a company depend on which country it operates in? The answer is yes, and here is why.

Business value is about risk and return. In other words, what makes a business valuable is how much money it makes given an acceptable level of risk. Investors, including business owners, look to put their money into business ventures that promise reasonable returns, both on their money and of their original investment.

Why business values differ by country

When sizing up business risk, the country’s economic and political conditions matter. Consider operating a company in a well run, developed economy such as Western Europe or North America. Political situation and the laws governing commerce are well understood and enforced. Financial markets are highly efficient and liquid. If you invest in a public company, you can unload your holdings in a few moments and move your money into a different investment.

The situation in less developed or politically troubled countries may be very different. The rule of law may be confusing or hard to discern. Exporting your money may well be fraught with difficulties or be very expensive. Bribes and protection rackets could plague the unwary investors. Your erstwhile business partners could turn out to be plain crooks.

Global financial markets abhor such instability. If the investors as a whole see systemic problems in a given country, they usually vote with their feet and take their investments to safer havens.

If you are adventurous, you may give investment in an emerging economy a shot. After all, risk and reward go together.

Unsurprisingly, the global investment community has a way to assess just how risky a business investment is in a given country. Consider how the discount rate for business valuation is built up. This discount rate captures the risk of your business investment. Note the equity risk premium, or ERP for short, in the equation.

Equity risk premium and country risk premium

For advanced, stable economies such as the USA or Western Europe, the ERP is measured by the returns on a major equities index, such as Standard and Poor 500 (S & P 500). The countries rated by the major credit agencies at the top of the scale get the Aaa rating. What this means is that investing in such countries is about as good a bet as investing in the broad portfolio of companies covered by the S & P 500 index.

Put differently, business investment in the USA, Canada, or Germany is no more risky than the equities market as a whole. Such advanced economies do not have any additional risk premium by country.

However, business values in less developed or stable countries is more risky. If you choose to invest in a company in many South American or Middle Eastern countries, your investment carries an additional country risk premium. How high the premium is depends on the risk spread of the particular country.

Example: business values in advanced vs developing countries

How does this country risk premium affect business values? Lets take an example of two companies, each generating $300,000 in net cash flows and growing at an annual rate of 5.47%. Both companies are debt free, so their cost of capital is just the equity discount or cap rate.

Let’s further assume that both companies are small, under $50M in market capitalization, and offer professional engineering services. The first company, based in the USA, has the equity discount rate made up of these parts:

Risk Element Risk Value, %
Risk free rate (based on US 10 year Treasury yields) 2.5%
Equity risk premium 5.7%
Country risk premium 0%
Small company size premium 11.59%
Industry risk premium 0.46%
Company specific risk premium (CSRP) 4.1%
Equity Discount Rate 24.35%

This gives the total equity discount rate of 24.35% and capitalization rate (cap rate) of 18.89%.

The second company in our example is based in Argentina, the country rated B3 by Moody’s. The country risk premium is around 9.3%, which gives us the total discount rate of 33.65% and cap rate of 28.19%.

Difference in business valuation by country

We next use the constant growth direct capitalization business valuation method to figure out what each company is worth. Remember, the only difference in this scenario is the country risk premium. Here are the results:

Business value of the US-based company

Business value: $1,675,230

Business value of the Argentina-based company

Business value: $1,122,506

As you can see, the difference in business value is considerable. Given a choice, any rational investor would go for the US company due to its lower risk. The Argentina based company would have to throw off more cash increasing its returns in order to compensate the investors for its higher risk.